Options In the Money and Out of the Money

An option's value, called its premium, fluctuates based on the price of the asset underlying it (such as a stock, ETF or futures contract). The option can either be In the Money, Out of the Money or At the Money, also know as ITM, OTM, and ATM. Let's look at each one of these states, and see how it affects the value/premium of the option.

In the Money

An option contract is in the money if it has intrinsic value. For example, a Call option is in the money if the price of the underlying asset is higher than the option contract strike price. Conversely, a Put option is in the money if the price of the underlying security is lower than the option contract strike price. As a brief reminder, call options are a bet that the underlying asset will rise in price, while a put option is a wager that the underlying asset price will fall.

It is called ITM because option traders are typically speculating on the price direction of the underlying asset. If the strike price of a call option is $5, and the underlying stock is currently trading at $4.70, that option is out of the money. The buyer of the call isn't going to make any significant money until the price starts rising above $5 (ITM). The higher above $5 the price goes, the more in the money the option is.

Out of the Money

An option contract is out of the money if it doesn't have intrinsic value. For example, a Call option is out of the money if the price of the underlying security is lower than the option contract strike price. Conversely, a Put contract is out of the money if the price of the underlying security is higher than the option contract strike price.

It is called OTM because option traders are typically speculating on the price direction of the underlying asset. If the strike price of a put option is $5, and the underlying stock is currently trading at $5.30, that option is out of the money (OTM). The buyer of the put isn't going to make any significant money until the price drops below $5 (ITM). The lower the price is below $5, the more ITM the trader is. The higher the price above $5, the more OTM the trader is.

Figure 1 (click for larger image) shows the progression of a stock moving from out of the money to in the money, as the underlying stock passes above the $37 strike price.

At the Money

If an option contract has the same strike price as the price of the underlying asset, the option is At the Money. If you buy a call or put option with a $5 strike price and the stock is currently trading at $5, those options are ATM.

ITM and OTM Examples

Let's look at few more examples to help clarify in the money options and out of the money options. If a stock--the underlying asset--is trading at $50, all call options with a strike price below $50 are in the money. Call options with a strike price above $50 are out of the money. For example, a call option with a strike price of $30 has $20 of intrinsic value, because the strike price is $20 below the $50 stock price.

All put options with a strike price above $50 are in the money, and put options with a strike price below $50 are out of the money. For example, a put option with a $60 strike price has $10 of intrinsic value, because the stock is trading at $50, $10 below the strike price. A call or put option is at the money (ATM) if it has a $50 strike price, and the underlying stock is also trading at $50.

Time Value

Whether an option is in the money or out of the money depends on the option's strike price and the value of the underlying security. This difference is known as intrinsic value but is not the only factor in the price -- premium paid -- for an option. Another factor is "time value."

Time value is the amount someone else is willing to pay for an option based on the probability and possibility that it will move into the money before expiry (there are calculations to aid in this assessment, called "greeks"). The longer the time until expiry, the greater the time value, since there is a higher chance that over a longer period of time the option will, at some point, be in the money.

When there is time until expiry, the premium of an option will reflect both the intrinsic value and the time value. If an option has no intrinsic value (out of the money) then it still has time value up until expiry. Calculating all the factors that go into the cost of an option (the premium) is a complex task. A simple way to think of it though is intrinsic value + time value.

If an option is out of the money, it has no intrinsic value, and therefore the premium is mostly composed of the time value. If an option has $10 of intrinsic value, the premium will be higher than $10 because of the time value.

Tying it Together

When you buy an option the price you pay is called the premium. This reflects the time value, as well as any intrinsic value the option may have. Intrinsic value is based on whether an option is ITM or OTM. Options can move in the money and out of the money, which will affect the premium until the option expires. On the day of expiry, the option will either be in the money or out of the money, and there will no longer be any time value.